The Theory of Perfect Competition Is Wholly Misleading

If neoclassical economists are correct, economic competition reaches its apex — a state of perfection — only when it ceases.

According to the supposed experts, competition is at its zenith when zero of it exists. It follows that any activity that to a non-economist appears to be competitive is, in econ-speak, an instance of “imperfect” or “monopolistic” competition. That activity isn’t competitive at all.

Has that automaker improved the styling of its mid-priced SUV? Does this motel chain advertise and boast about the increased spaciousness of its guest rooms? Did that bakery introduce a new, tastier mix of granola? When a non-economist witnesses such activities, she immediately understands that these sellers are competing for buyers.

But when a neoclassical economist witnesses such activities, he detects nefariousness afoot. Any seller that manages by means other than cutting prices to make its product more attractive to consumers thereby escapes the necessity of cutting its prices as much as possible. Some degree of competition might still exist insofar as this seller is restrained by market forces from raising its price.

But to the extent that this seller successfully uses, not price cuts, but the likes of advertising, branding, or product differentiation to persuade consumers to buy more of its output, this seller has monopoly power. And use of this monopoly power distorts the allocation of resources by causing that allocation to differ from what it would be in the absence of this monopoly power.

In this world, to build a better mousetrap is not to compete and to enrich but to monopolize and to impoverish.

Consumers Care About More Than Prices

How can it be that economists’ conception of competition is so bizarre? The answer is that for neoclassical economists competition is defined to operate only on prices. Successful attempts to increase sales by doing anything other than cutting prices, therefore, are not only not competitive, they are monopolistic because they decrease sellers’ need to cut prices.

Further, this competition isn’t perfect until all firms are under such intense pressure to keep prices as low as possible that even the slightest price hike by an individual seller causes that seller to lose all customers. This outcome is guaranteed by the assumed existence of such a multitude of other firms selling the identical product that consumers who abandon the price-hiking seller can effortlessly satisfy all of their demands for this product simply by switching their patronage to the other sellers.

In a “perfectly competitive” market, sellers have no further need to cut prices. And because competition is defined only as cutting prices, sellers also have no further scope to compete. The only decision consistent with “competition” left for each seller to make is how much output to sell at the prevailing market price.

Sellers, then, don’t actually compete in perfectly competitive markets. Instead, they merely react to given market prices exclusively by adjusting the quantities they produce.

Not All Simplifying Assumptions Are Created Equal

Although economists have long recognized that the assumptions on which the theory of perfect competition rests never actually describe reality, this theory nevertheless sets the standard against which economists continue to assess the competitiveness of real-world markets. The more closely real-world market structures and outcomes resemble those of a perfectly competitive market, the more competitive do neoclassical economists judge real-world markets to be.

These economists justify their use of the theory of perfect competition by correctly noting that no theory accurately describes the reality that it is meant to explain. But in this case this justification fails completely.

It’s true that all theories rest on simplifying assumptions. Yet when neoclassical economists justify the unreality of the assumptions at the heart of the theory of perfect competition, they reveal an apparent belief that simplifying assumptions are a sufficient condition for generating useful theories.

Yet this belief is false. Assumptions are not justified merely because they are simplified. Instead, simplifying assumptions are justified only if they result in theories that enhance our understanding of phenomena that we seek to better understand.

Do the assumptions at the heart of the theory of perfect competition enable us to better understand competition in reality? You decide. This theory assumes that

  • the products available for sale have already been developed in all relevant details;

  • firms never compete for customers by improving the quality or otherwise changing the features of products they offer for sale;

  • each firm in an industry produces outputs that are identical in consumers’ minds to those produced by every other firm in that industry;

  • such a very large number of firms exist that no firm has any control whatsoever over the price it charges; each firm can sell as much as it wishes at the prevailing market price, but if it charges any higher price, it makes no sales;

  • both consumers and producers are fully informed about all relevant features of the products and of the market, including knowledge of the most efficient means of producing and distributing the outputs; and

  • firms enter and leave each perfectly competitive industry instantaneously.

Except, perhaps, for the last of these assumptions, to use this set of assumptions is to assume away the very phenomenon that the theory of perfection competition ostensibly is meant to explain: competition.

In real-world markets, for a firm to compete means for that firm to strive in any peaceful manner it likes to entice consumers to purchase more of its outputs. One way of so enticing consumers, of course, is to cut prices. But cutting prices is hardly the only way, and it’s certainly not the way that’s most creative. Other ways of competing include improving a product’s appearance, performance, and durability.

Even better is to introduce an entirely new product. The most casual survey of reality reveals these means of competing to be just as important to consumers as are cuts in prices. Yet in the theory of perfect competition, these non-price means of competing are assumed away.

Also assumed away are advertising and other marketing efforts by sellers to better inform consumers about available product offerings. After all, consumers who by assumption are fully informed can learn nothing worthwhile from advertising or other means of marketing.

And to assume the existence of a multitude of producers each selling outputs identical to those of other producers in their industry is to assume that entrepreneurs have already learned not only that it is profitable to operate in whatever perfectly competitive industries they now operate, but just how to operate profitably in those industries.

According to this theory, firms enter industries mechanically and instantaneously whenever the prevailing market prices are sufficiently high to allow entrants to operate profitably. A firm entering a perfectly competitive industry performs a feat that is no more competitive than that which is performed by a pedestrian who, noticing a $20 bill on the sidewalk, bends down to pick it up.

The Theory of Perfect Competition Is Wholly Misleading as a Guide to Real-World Competition

If the above disquisition reads too much like inside baseball (or inside academic economics), it is warranted by the recent rise in the number of calls for more active antitrust enforcement. Very many such calls refer, explicitly or implicitly, to the theory of perfect competition. These calls treat this theory as if it supplies an unquestioned, and unquestionably sound, standard against which to judge real-world markets.

But in fact the theory of perfect competition should be utterly rejected, both as a theory of competition (which it is not) and as offering an appropriate standard against which to judge real-world markets (which it does not).

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Donald J. Boudreaux

Donald J. Boudreaux is a senior fellow with American Institute for Economic Research and with the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center at George Mason University; a Mercatus Center Board Member; and a professor of economics and former economics-department chair at George Mason University. He is the author of the books The Essential Hayek, Globalization, Hypocrites and Half-Wits, and his articles appear in such publications as the Wall Street Journal, New York Times, US News & World Report as well as numerous scholarly journals. He writes a blog called Cafe Hayek and a regular column on economics for the Pittsburgh Tribune-Review. Boudreaux earned a PhD in economics from Auburn University and a law degree from the University of Virginia.